Pay Down Debt or Build an Emergency Fund?
Although I’m not a financial professional and I don’t normally give advice, I’m relatively comfortable offering some opinions when it comes to strategy. A reader presented this question to me recently. I’m open to answering questions as long as the answers don’t involve giving stock picks or legal advice.
My wife and I recently moved across the country, going into debt in order to throw our lives into upheaval. We both have contract positions, so our income tends to fluctuate. At the moment, it’s steady, and we can pay our bills have some left over to pay off our debt. I’m concerned that this won’t always be the case and our income might drop, requiring us to live on credit again because we don’t have enough savings to cover our expenses other than savings accounts that have been designated for things, like taxes. I really want to get out of debt, though, and I’d like to put all of our extra income to paying off debt.
Being in debt can be demoralizing, especially for someone who has been reading at least one personal finance blog for several years (as I believe this reader has). In this case, we’re not dealing with debt that some might consider good, like student loan debt, or for some tricky manipulators, 0% balance transfers. Credit card debt for regular expenses, the type of debt that isn’t paid off immediately at the end of the month, is universally considered damaging to a family’s finances in the long term. Financial education creates a strong aversion to this type of debt.
Yet, attacking credit card debt with the full force of anything left over from a paycheck is not always a good thing. While the feeling of eliminating debt is great, without some cash ready to be deployed in the vent of an emergency, that credit card will return. For some people, emergencies just tend to keep happening, because anything you haven’t saved money for has become an emergency.
If there are savings accounts designated for other expenses, they could be usurped by a formal emergency fund for now, but if these cash accounts are being held for tax bills, as employers often don’t withhold taxes for consultants working independently, then it’s best to leave these accounts alone. If the savings is designated for a new camera or next year’s vacation to Cabo, the better financial decision is to shore up the emergency fund before using the money to head to the shore.
He’s a fan of the Balanced Money Formula, which suggests creating three buckets for after-tax income. 50% of the net income goes to “needs,” 30% to “wants,” and 20% to “savings.” In our discussion, the reader considered splitting the savings category into 10% savings (in the form of an emergency fund) and 10% paying off credit card debt. I originally placed debt under the savings banner when describing a method of budgeting based on Maslow’s Hierarchy of Needs, but that might not be appropriate.
The minimum monthly payment to credit cards must fall under “needs,” because if these payments are not met, the credit card issuer will penalize the borrower with higher interest rates. In the worst case scenario, the debt could go into collections and ruin the borrower’s credit rating. This is a costly mistake. But where do extra debt payments fall in?
When paying off high-interest credit card debt is a goal, it’s more important than wants. If you’re going with the Balanced Money Formula, debt elimination is a need or a want. If there is no existing emergency fund, the last 20% for contributing to a savings account should also be prioritized as a need, and this supersedes the need to pay extra money towards credit card debt beyond the minimum payments. If the only after-tax income you have after paying the necessary bills is less than the 50% for wants and savings, you’ll find that extra debt payments and building up a savings account compete for priority.
Starting the emergency fund should be the winner of that battle. At least get an emergency fund started with maybe $1,000, $2,000, or the cost of one month’s worth of expenses in the bank.
Once that has been accomplished, return to the Balanced Money Formula. At this point, you’d be able to pay down debt faster than the minimum payments alone while continuing to build an emergency fund.